This is a guest post by Braaak, former Portfolio Manager at a major mutual fund family. Currently Braaak provides insurance and other financial services to high net worth individuals and small- to medium-sized companies. He writes regularly and without regard for a consistent theme or style at “Up is Good, Down is Bad“. He hangs out in Central NJ with his wife of 17 years, 3 kids and one ugly water frog.
Do you know exactly why, even if you can afford it, it probably doesn’t make sense to pay off your 1st, and maybe even your 2nd mortgage?
The U.S. National Debt is almost universally decried by popular media as being a bad thing. Is it?
Do you know why, when companies need money, they sometimes issue stock and sometimes sell debt (bonds)?
What is Optimal Capital Structure?
Optimal Capital Structure (OCS) is the financing (getting money) mix that minimized the cost of capital and therefore maximizes the value of the entity that is using the capital (money) to do stuff. OCS also has important implications for personal finances and amateur investors alike.
In less formal terms, your family needs money to do stuff. Whether you are going to a movie or buying a house, you have two choices: you can pay cash or finance it via credit card, mortgage or bank loan. Neither choice is inherently bad. The mortgage choice is, in fact, obviously good in most cases.
Let’s say you have a mortgage at 6%. If your marginal federal tax rate is 28% then the real after tax cost of your mortgage is 6% x (1-.28) = 4.32% before considering state taxes. You are borrowing long-term money at 4.3%. You should be able to invest long-term money in the financial markets and earn a return that is greater than 4.3%, so your mortgage is an important component of your OCS. And it frees up cash to do and buy other stuff.
The U.S. Government probably has too much debt currently but will always have some, for the right reasons. The U.S. has some assets – gold reserves, land etc., but its biggest asset is its ability to tax people and companies pretty much whatever it wants. The Government is responsible for taking care of the population – building roads, protecting the borders etc. By using some debt, the Gov’t can do these things when it sees fit without (a) waiting for the tax receipts to roll in or (b) printing money. Plus, The U.S. Gov’t can borrow more cheaply than most entities. If you buy a 10-year Treasury bond today, you are in effect lending the Government money for 10 years at 3.9%. Cheap. If the Gov’t prints more money, the dollar goes down and nobody goes to Europe.
If you follow me on the two above examples you probably get where I’m going when it comes to investing. All companies, and individuals, have a cost of capital. If they sell stock, investors expect a return, often a high return for higher-risk companies. If companies borrow money, the lender demands interest payments.
Companies are charged with maximizing shareholder value. If company XYZ’s equity (stock) investors expect the stock to go up 10%+ per year, and XYZ can borrow money at 6%, XYZ should have some debt. You don’t have to watch CNBC for long before you’ll here some market participant say, “blah, blah, the stock is cheap and the company has no debt” as if that is obviously good thing. It isn’t. If a company can borrow at attractive rates and interest payments are not so high that the company would have to refinance under worse terms in a downturn, some debt is good.
Debt is not a bad thing. In fact some debt, especially at favorable rates and reflecting available tax advantages, is a good thing.
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